OMOs are tools in monetary policy that allow a central bank to control the money supply in an economy. Under a contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation. Expansionary monetary policy entails the purchase of securities and an increase in the money supply. Changes to the money supply affect the rates at which banks lend to one another, a reflection of the basic law of supply and demand.

Real-Life Examples

In 1979, the Fed under Chairman Paul Volcker began using OMOs as a tool. To combat inflation, the Fed started selling securities in an attempt to reduce the money supply. The amount of reserves shrank enough to push the federal funds rate as high as 20%. 1981 and 1982 saw some of the highest interest rates in modern history, with average 30-year fixed mortgage rates rising above 18%.